Steve Lambert, Open Clip Art Library - Sitting Elephant, 2007.

               If the ends don’t justify the means,
                              What does?

Global Insight reports that housing market conditions continue to deteriorate. Revival will require the participation of more than “just” the government controlled housing agencies - Ginnie Mae, Fannie Mae, and Freddie Mac.  It will also require the revival of the private label MBS market. 

Prior to what we quaintly called “the subprime crisis”, private label securitizations - of jumbo, subprime, or “AltA” loans - accounted for roughly half the market. New private label MBS issuance is virtually non-existent today, due to lack of investor confidence reflecting their unexpectedly poor credit performance.

Governor Randall S. Kroszner of the Federal Reserve, and Erik F. Gerding, Assistant Professor of Law at the University of New Mexico, have independently looked at the issue and described ways to revive the private label, i.e., non-agency, market.

This ambitious post will summarize each of their suggestions and then describe the means, or the methods, that could be used to realize their prescriptions and revive the jumbo and non-agency sectors.

KROSZNER: HOW TO REVIVE NON-AGENCY

Dr. Kroszner focused twice during the last week on the stable revival of the non-agency MBS markets [See References]. Below is my summary.

Private label securitizations should be fundamentally changed.  These changes include:

1. Provision of easily accessible, comprehensive, and standardized loan-level data describing all of the loans in each mortgage backed security;
2. Simplification of MBS cashflow structures and increased homogeneity of loan types with each securitization;
3. Standardization of securitization contracts; and
4. Reduction in the number and increase in size of MBS tranches, to increase liquidity and decrease uncertainty with respect to what might happen under unusual circumstances.

With this promotion of standardization and simplification, investors will be able to conduct independent credit analyses in addition to that provided by the traditional credit rating agencies. This should gradually, over time, rebuild investors’ confidence in the private label MBS structure and non-agency loans.

The current situation, Dr. Kroszner believes, reflects the initial development of the MBS market, which began with the issuance of government or quasi-government guaranteed securities by Ginnie Mae, Fannie Mae, and Freddie Mac.  These guarantees limited the benefit of private sector credit analyses of these assets (they were guaranteed, right?), discouraging the development and dissemination of tools to thoroughly analyze residential mortgage credit.

As a result, the mortgage market never fully developed the standardized grading conventions that facilitate “the unambiguous specification of quality” such as that promulgated by the Chicago Board of Trade in 1856 for wheat.  The incompleteness of this standardization can perhaps best be captured by the question often asked by investors in “Alt A” loans.  Specifically “What is Alt A, anyway?”  Or equivalently - “How does your Alt A differ from their Alt A?”

Dr. Kroszner views the historical underinvestment in analytic infrastructure as one of the reasons that investors could not keep up with the 2005-2006 expansion and complexity in private label MBS.  This led to an under-appreciation of the risk-layered dangers in the jumbo, subprime, and Alt A market.

• Note:  If you can, try to get a hold of the early (and prescient) Non Agency Mortgage Credit Performance, which appeared in the 28 Nov 2006 UBS Mortgage Strategist.  The UBS’ analysts determined that a combination of higher loan-to-value & debt-to-income ratios, lower credit scores, and other ‘affordability’ features (such as limited documentation and non-traditional amortization terms) interacted with each other to produce the poor credit performance that signaled the start of today’s problems.

Dr. Kroszner believes that his suggestions will promote a gradual recovery - of confidence and markets – in non-agency MBS.

GERDING: HOW TO INSOURCE TRANSPARENT “CODES”

Professor Gerding has graciously granted me permission to discuss his forthcoming paper - The Subprime Crisis And The Outsourcing Of Financial Regulation To Financial Institution Risk Models: Code, Crash, And Open Source, which is available on SSRN [see References].

Lets begin first by noting (for you do-it-yourselfers) that his 82-page paper (the “Paper”) is NOT as long as the page count suggests.  First, the text is double-spaced.  Second, Professor Gerding provides copious footnotes.  For what it’s worth, it felt like it was “only” a 25-page paper, and provides a fairly comprehensive and original overview of the securitization and subprime markets. There is no way I can do it justice here.

Professor Gerding’s novel work suggests that cyberlaw scholarship can provide perspective on how the crash of computer-based “codes”, particularly risk models, triggered the subprime mortgage crisis and suggests ways to mitigate these risks.

Gerding’s approach reveals a critical flaw in financial regulation.  Specifically:

• Regulators outsourced vast regulatory authority to the proprietary codes of financial institutions, without examining defects in those codes.

Financial codes now drive:

• The types of mortgages and other financial products that financial institutions market to consumers;
• The manner in which financial institutions securitize those products;
• How institutions that purchase asset-backed securities hedge risks; and
• Overall risk management by financial institutions.

At each of these nodes in the financial network, regulators relinquished significant oversight responsibility to the “new financial code.” This practice continues today.

Professor Gerding concludes:

• Regulators can NOT outsource oversight over “codes” (including loan underwriting and risk models);
• Regulators must have the ability to conduct regular technical audits that critically examine financial institutions’ codes;
• Financial institutions’ incentive structures must be consistent with broader public policy concerns;
• Both financial instruments and financial regulation should be simple;
• If risks are transferred (by “code”) to consumers or investors that are “ill-prepared”, the losses can be catastrophic;
• Financial code should be transparent and open, similar to open-source software;
• Rating agencies’  “dismal track record” and “monopoly power” over issuers and transactions cannot be remedied by simply changing their compensation methods or increasing their legal liability, and regulators should attempt to develop solutions that do NOT increase rating agencies’ influence.

ARTMAN: OWNERSHIP - IT’S A WONDERFUL THING

I believe that the effective nationalization of much of the financial industry provides the method to realize both Dr. Kroszner’s & Professor Gerding’s suggestions.  The government is at once the lender of last resort, owner of last support, and regulator of coerced extort.

Believe that the current scope of the US government’s control over the financial sector would be the envy of Prime Minister Vladimir Putin.

At this point, the US government effectively controls Ginnie Mae, Fannie Mae, and Freddie Mac. In addition, it controls what had once been the largest insurance company as well as the largest commercial bank. Those that are not under direct control are certainly in, as they say, Mr. Bernanke’s and Mr. Paulson’s (soon-to-be Geithner’s) neighborhood.

So how to proceed?

We’ve tried the purchase route, via TARP, and respectfully suggest that we’ve arrived at the “If all you have is a hammer, then everything looks like a nail” stage of transactional government in which the government buys everything.  So ….?

Believe that it’s time to have a SALE. 

Dr. Kroszner described how non-agency securitizations might resume if the underlying loans’ characteristics were completely disclosed on a loan-by-loan basis as they were securitized in simplified transactions with standardized contracts.

But in order for non-agency securitizations of this type to succeed, believe that the government must pave the way with similar transactions (with respect to disclosure, structure, and documentation) using conforming loans or assets that are presently under the government’s control. 

These conforming transactions would, literally, set the standard, for the non-agency/non-conforming transactions that would follow.  Development costs, and standards, to be developed for the conforming loans (as suggested by Dr. Kroszner) would then be redeployed and reused on the non-agency loans.

The balance sheets of controlled entities (see above) contain assets that could be re-jiggered to provide collateral for simplified senior-sub transactions based on relatively homogeneous, fully disclosed collateral.  Investors could become familiar and comfortable with standardized transactions, systems, and contracts developed for conforming collateral. 

While many of the assets are in agency ‘guaranteed’ MBS, if the government needs to resuscitate the senior sub model, I imagine that they could find a way to remove the guarantee from those assets that would “back” the subordinate (and senior?) tranches.

• Note: Professor Gerding emphasized that the dangerous “monopoly power” of the rating agencies can NOT be rebalanced by altering their compensation methods or legal liability.  Maybe not, but if a significant portion of their compensation was paid in the form of subordinate classes of their rated transactions, wouldn’t that help, at the margin?

As investors’ comfort increases with these new fangled simple structures, non-agency loans could be re-introduced in distinct homogeneous transactions, along the lines suggested by Dr. Kroszner.

Professor Gerding’s suggestions - for open source codes, standards, models and risk management that are subject to critical and technical audits  - at one time might have seemed to be an idealist’s dream, with little hope of realization.

But if THE lender, owner, and regulator cannot insist that the financial industry ”open up” and submit all of their open codes for a thorough technical audit, then I know of someone who can.

His first name is Vladimir, he holds 6th degree black belt in Judo,  and I’m sure that he will be able to convince (former) Masters of the Universe of the wisdom of both Professor Gerding’s, and Dr. Kroszner’s, prescriptions.
- - - - - - - - - - - 

I used to work with numbers for a living, but now I am trying to figure out why no one else has noticed that if you want to get a big elephant out of the room, you simply start with peanuts… Looking for my job or at least my next idea.  Till next time.

REFERENCES
     
E.F. Gerding, University of New Mexico/Washington Law Review (Forthcoming) - The Subprime Crisis And The Outsourcing Of Financial Regulation To Financial Institution Risk Models: Code, Crash, And Open Source, 16 Aug 2008 Draft .
R. S. Kroszner, Governor, Federal Reserve - Improving the Infrastructure for Non-Agency Mortgage-Backed Securities, 4  Dec 2008.
R. S. Kroszner, Governor, Federal Reserve - Assessing the Potential for Instability In The Financial Markets, 8 Dec 2008.
Steve Lambert, Open Clip Art Library - Sitting Elephant, 2007.